Dividend aristocrats are an exclusive group of companies that have increased their dividends for at least 25 consecutive years. In this article, we’ll define what the dividend aristocrat index is, the requirements to become part of the club, and the benefits of investing in these companies. We’ll also touch on the best ways for investors to gain exposure to the companies in the index.
Stocks That Deliver Slow and Steady Growth
Investing in dividend stocks is not a flashy way to wealth. Investors won’t achieve the market-beating gains that might come from a small cap technology stock. However, they also won’t be exposed to the stomach-churning losses that can haunt investors who chase large returns.
That doesn’t mean investors must sacrifice growth altogether. Dividend aristocrats are a group of dividend stocks that not only consistently deliver growing dividends, but also deliver performance that regularly outpaces the S&P 500 index.
That means investing in dividend aristocrats is one of the most efficient ways for investors of all risk tolerances to build wealth over time. These companies demonstrate a commitment to building shareholder value by prioritizing raising the payout on their dividend.
What is the Dividend Aristocrat Index?
The dividend aristocrat index is a group of blue-chip S&P 500 companies with a documented history of increasing dividends for at least 25 consecutive years. Membership to this club is exclusive, but can be achieved by any company that meets the following requirements:
- Their stock must be listed on the S&P 500
- They must have at least 25 consecutive years of dividend increases
- They must meet certain market cap and liquidity requirements. Currently, a company must have a float-adjusted market cap of at least $3 billion (meaning these are large-cap companies). In terms of liquidity, a dividend aristocrat should have an average trading volume of at least $5 million.
Are Dividend Aristocrats Good Investments?
Any company that has both the desire and the ability to generate increased dividend payments for their shareholders is a stock worth considering. But for investors new to dividend stocks it’s important to note that dividend stocks are regarded as defensive stocks.
Defensive stocks get their name because of their relative consistency in both bull and bear markets. Simply put, these companies have products that remain in demand no matter what is happening in the economy.
Adding to this, these companies have a track record of maintaining, and growing its dividend for more than two decades. That is further assurance that the company has a business model that can provide stability even when the economy is slowing. And for income-oriented investors this can be a distinct competitive advantage.
What is a Dividend?
Before we go too much further, let’s define what a dividend is and why it has a role in a diversified portfolio. A dividend is a portion of a company’s profit paid to investors in the form of a dividend. Companies generally pay their dividends quarterly although there are a handful of companies that pay a monthly or annual dividend.
Shareholders of record receive their dividend either as a paper check or direct deposit in the account they specify. Many dividend stocks also give investors the opportunity to reinvest their dividend in the company. This is a passive strategy that allows an investor to increase their total return in a stock if they don’t need the money right away.
What Makes Dividend Aristocrats Different?
The benefit of investing in dividend stocks is that investors receive income on a regular schedule no matter what is happening with the company’s stock price. But of course this is only a benefit if a company continues to offer its dividend.
Some companies need to suspend their dividend. Other companies may maintain their dividend at one level for many years. Both of these scenarios suggest that there may be underlying financial issues that affect a company’s ability to pay a dividend.
Dividend aristocrats make a priority of setting aside a portion of their cash flow to be paid out as a dividend. This purposeful review of capital allocation likely adds to shareholder value. Another characteristic of dividend aristocrats is that the ability to reward their shareholders with cash payments speaks to the idea that these are well-run businesses.
This brings up another difference of dividend aristocrats. Many of these companies are in a mature phase of their business cycle. This means that they are generating sufficient revenue to meet their short-term obligations with enough free cash flow (i.e. retained earnings) to payout and increase their dividend.
How Dividend Aristocrats Can Increase an investor’s Total Return
Defining proven performance with dividend stocks can be tricky. After all, dividend stocks are often thought of as something for investors with a low risk tolerance. Investors get the benefit of low volatility with the tradeoff of performance that may lag behind the broader market.
However, that’s not the case with the stocks that make up the dividend aristocrat index. In fact, the companies that make up the index have generated exceptional, risk-adjusted returns over the last 25 years, and since the financial crisis of 2007, these companies have consistently outperformed the S&P 500, and frequently they did so by a large margin.
This is significant because it’s easy to talk about the performance of a dividend stock in a bear market. While these stocks are not “recession-proof”, they have proven over time to generate strong cash flows even during a recession. A dramatic example of this would have been in 2008. The S&P 500 suffered a 38% loss. However, the companies that made up the dividend aristocrats index only declined 22%. You would expect that from defensive stocks.
But in the subsequent years, the stock market went on a historic bull run and these dividend aristocrats still beat the S&P 500 Index, giving investors both higher total returns with less volatility. What more can an investor ask for?
Of course, like any stock an investor may choose to add to their portfolio, not all the stocks on the dividend aristocrat index are equally good investments at a particular time. Investors should pay attention to fundamentals like price-to-earnings ratio and dividend yield to decide which stock(s) may be right for their objectives.
Can a Dividend Aristocrat Fall Out of the Index?
The requirements to become a dividend aristocrat are stringent. And once a company makes the index, they have to continue to meet the requirements to retain their status. Standard & Poor’s is the company that oversees the index. They rebalance the index every year in January. At this time, some companies may be added and some taken off.
However, generally speaking, once a company earns admittance into this exclusive club, they will generally make staying in the club a priority.
How to Invest in the Dividend Aristocrat Index
There are many financial web sites that provide a list of the dividend aristocrats. Many allow investors to compare stocks based on a number of criteria including price-to-earnings ratio, liquidity and dividend yield. Many investors get a lot of satisfaction out of performing the fundamental analysis needed to find a quality stock. In many cases, an investor may only need to have a handful of these stocks in their portfolio to get the diversification they are looking for. And, to be fair, not all of these stocks grow at the same rate or at the same time.
However, many passive investors don’t have the time or the expertise to research individual stocks. Fortunately, they have options as well. One of the best ways to invest in the dividend aristocrat index is through index funds or exchange-traded funds (ETFs). These funds provide diversification and a low cost structure. While index funds and ETFs behave fairly similarly there are some important distinctions, particularly in the way dividends can be reinvested. In an index fund, dividends are immediately reinvested, while ETFs continuously accumulate dividends and distribute them quarterly. However, on the other hand ETFs provide are more tax-efficient and can offer investors more choices than index funds. Some of the more popular funds are:
- SPDR S&P Dividend ETF (SDY)
- ProShares S&P 500 Dividend Aristocrats (NOBL)
- SPDR S&P Global Dividend ETF (WDIV)
There are several other funds that track dividend stocks, but don’t directly follow the index, or may expand their guidelines to include companies that have issued fewer consecutive years of increasing dividends. However, increasing the range of companies does not necessarily improve performance. The reason why the dividend aristocrats have achieved their status is because of their commitment to providing dividends for at least 25 years, and in many cases far more than that.
Limitations of the Dividend Aristocrat Index
If there’s one critique of the methodology it’s that some of the companies in the index engage in the practice of share buybacks. On the face of it, it’s a reasonable concern because when a company buys back its own shares it sometimes indicates that a company has limited growth potential. It can also be done to make earnings and growth look stronger than it actually is.
However, this is one of those scenarios where context is very important. Many corporations are under intense pressure, and incentivized to buy back shares if their stock is perceived to be undervalued. And issuing dividends and stock buybacks does not have to be an either/or proposition.
The key thing to remember about the dividend aristocrats is that if these companies are occasionally buying back their own shares they are also still issuing dividends. And not only dividends, but dividends that continue to increase every year. So while some purists may not like the practice of stock buybacks, in practical terms and by definition of the index’s own selection criteria, this is not a valid concern.
The Bottom Line on the Dividend Aristocrat Index
Dividend aristocrats are solid companies who have demonstrated the ability to issue increasingly rising dividends for at least 25 years. Membership in this club is exclusive and while some companies can be removed from the index, the reality is it typically takes a major event such as the financial crisis of 2008 or the long, steady decline of a one-time powerhouse like General Electric to move a company off the index. Most companies are very proud of their aristocrat status and make the ability to add shareholder value through issuing dividends a primary objective of their business.